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?Investors are ?normal,? not rational,? says Meir Statman, one of the leading thinkers in behavioral finance.
Behavioral finance aims to better understand why people make the financial decisions they do.? And it?s a booming field of study.? Top behavioral finance gurus include Yale?s Robert Shiller and GMO?s James Montier.
It?s also a crucial part of the Chartered Financial Analyst (CFA) curriculum, a course of study for financial advisors and Wall Street?s research analysts.
We compiled a list of the seven most common behavioral biases.? Read through them, and you?ll quickly realize why you make such terrible financial decisions
Your brain thinks it?s great at investing
Overconfidence may be the most obvious behavioral finance concept.? This is when you place too much confidence in your ability to predict the outcomes of your investment decisions.
Overconfident investors are often underdiversified and thus more susceptible to volatility.
Source: CFA Institute
Your brain doesn?t know how to handle new information.
Anchoring is related to overconfidence.? For example, you make your initial investment decision based on the information available to you at the time.? Later, you get news that materially affects any forecasts you initially made.? But rather than conduct new analysis, you just revise your old analysis.
Because you are anchored, your revised analysis won?t fully reflect the new information.?
Source: CFA Institute
Your brain is too focused on the past.
A company might announce a string of great quarterly earnings.? As a result, you assume the next earnings announcement will probably be great too. This error falls under a broad? behavioral finance concept called representativeness: you incorrectly think one thing means something else.
Another example of representativeness is assuming a good company is a good stock.
Source: CFA Institute
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